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Interest rates: Will he, won't he? - Views on News from Equitymaster
 
 
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  • May 13, 2004

    Interest rates: Will he, won't he?

    There have been three great inventions since the beginning of time: fire, the wheel, and central banking. Will Rogers

    Probably, no other quotation would exemplify the importance of central banking more than what has been said above. Especially in these times, when global economies and their financial systems look more integrated than ever before, there has been a constant pressure on central banks worldwide to adjust their policies to global developments. And similar has been the story for the Indian central bank, the Reserve Bank of India (RBI). Over the years, especially over the past decade, the RBI has taken policy measures that have helped the cause of the Indian economy in its initiatives of becoming more liberalized and more attuned to changes in the global environment.


    Source: World Economic Outlook 2004 (IMF)

    Take for example the interest rates structure in the country. Here, by interest rates, we mean the 'bank rate', or the rate at which banks borrow money from the RBI, interest rates in India begun their downward movement. This softening process was much guided by the need to taper the effect of slowdown due to the Asian financial crisis that had spread across much of the South and East Asian region. However, there was a brief period in the beginning of 1998 (January-May 1998) when the RBI actually resorted to tightening of rates to prevent a run on the Indian rupee due to outflows on account of the Asian crisis. This factor, combined with those like the relatively lower quantum of foreign inflows and the strength of Indian financial system, helped the Indian economy keep away from the contagion that had spread across Asia.

    However, a major hit to the Indian economy came after the technology-led stock market crash of 2000 that further led to a slowdown across the global economy. The Indian economy was not spared this time because, due to the slowdown that severely affected global industries, Indian exports had collapsed. The RBI reacted again and lowered the bank rate in expectation that cheap money would revive food and non-food credit off-take. While the initiatives seemed unsuccessful for the initial period of time, the effects started to flow in as time progressed.

    One cannot deny the objectivity of the soft interest rate policy adopted by the RBI towards propelling growth of the Indian economy. This regime has helped the Indian industry clean its books of high-cost debt, and as a result, give a boost to its overall profitability. This has, then, gone a long way in improving the global competitiveness of Indian companies helping India to move ahead in its pursuit of the 1% global trade share target.

    Another major beneficiary of this soft interest rate regime has been the Indian government, who has been the largest borrower from the financial system. But this has acted as a double whammy for the Indian economy. This is because while lower interest rates have helped to reduce the interest liabilities, these have incited the government to borrow more, and more, thus crowding out private investment. However, this increased ability of the government has not led to higher inflation in the economy (as government borrowings lead to rise in money stock). This is because, as the Indian government increased its spending, there was a corresponding increase in the output levels in the economy that matched increased demand that has been a result of a higher spending power.


    Source: World Economic Outlook 2004 (IMF)

    I wasn't affected by inflation. I had nothing to inflate...

    As mentioned above, while the RBI's soft interest rate regime followed over the past few years has helped the government's spending (or overspending!) requirements and Indian corporates' initiatives in improving their efficiencies, there has been one lot that has borne the brunt - the small investors. These investors, a majority of whom are ripe in age or at the brink of it, have had been investing their lifetime of earnings into fixed income securities that give them risk-free returns. Now, not only have they seen their returns deflate by reduced interest rates, but they have also been left to live with the fact that their real returns have been reduced due to inflation (however less it may be) propelled by this soft interest rate regime. Thus, it would be the small investor who would be looking forward to the governor's stance on interest rates, as this would determine his savings and (real) returns on his investments.

    Would it be a 'heads I win tails you lose' policy?

    As the time for announcement of the yearly review of the monetary policy for 2004-05 nears, all heads are turning to see what Dr. Reddy will do to interest rates. Whatever be his decision, it would be indeed a tough one. Tough because if he decides to raise interest rates now when the Indian economy is finally looking good, it might act as a dampener on this growth process. On the other hand, if he does not raise the rates, he would be in a tight spot over inflation that has been rising, one major reason being the rising crude oil and commodity prices. Also, a 'non-stance' on interest rates would leave the small investors wait for another round of policy announcements that might 'bestow' upon them at least the minimum 'riches' that they deserve!

     

     

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